In public securities markets, market mechanics and trading psychology create barriers to efficient information dissemination and price discovery. A market participant's decision to reveal information regarding a large trading interest typically represents a tradeoff between confidentiality and liquidity. As used herein, the term “market participant” refers to any person or firm with the ability to trade securities; examples of market participants include broker-dealers, institutions, hedge funds, statistical arbitrage and other proprietary trading operations, and private investors trading on electronic communication networks (ECNs).
By publicly revealing the details of a significant active buying interest, for example, a market participant assumes the risk of adverse price action—other traders may view his buying interest as an indication that the stock is worth more than its current price. Other market participants that had legitimate selling interests, and market makers that seek short term trading profits, will “fade” their offers (become less aggressive sellers), resulting in an increase in the market price. There is also an empirically demonstrable risk of adverse price action due to “front running” (buying activity by other market participants in anticipation of price movement resulting from the large revealed order).
Confidentiality can be maintained to some degree by slicing the large order up into many small pieces to avoid arousing interest, but this process either fails to fill the order quickly when the trader is most careful to hide its existence, or if when it is worked at a faster rate, information about the existence of the order leaks out leading to much the same effect as the above mentioned order display problem.
In either case, an economically efficient transaction is missed because the trading costs associated with disseminating information are too high.
Trading large blocks on the New York Stock Exchange floor is also hindered by rules designed to protect the interests of floor brokers representing short term trading interests, and the proprietary trading interests of the specialists themselves. Floor brokers can participate with an Institutional order, taking an equal portion of the liquidity coming in on the contra side, to take a short term speculative position with the safety net provided by the larger Institutional order; or “penny jump” on the Institutional order by intercepting the contra-side liquidity with a one-cent better price, rather than allow it to fill the Institutional order. Specialists utilize various methods including penny jumping to extract profits from information about Institutional activity; invariably these activities lead to adverse price movements and lower fill rates for the Institutional orders.
Another known difficulty with trading large blocks is one that is sometimes called the “buyer's remorse” problem. When a trader places a large block and gets it filled quickly, the trader's natural reaction is to believe that the easy fill indicates that it was a poor trading decision—either there was a much larger contra whose residue will subsequently drive the price adversely, or the block's price was too attractive, leading to its quick acceptance. This “buyer's remorse” effect leaves the client unsatisfied and unlikely to place similar orders through this same channel in the future, since the quick fill would be perceived as a failure of this channel to provide protection from a poor trade.
One known approach to matching trading interests and executing block trades while limiting information dissemination is employed by the POSIT® matching system. The POSIT® system allows trading interests to accumulate and initiates a matching sequence at set intervals. Market participants place confidential orders in the system and are unaware of the amount or aggressiveness of other orders on the same side or on the contra side until the matching is released. This approach does not provide for any mechanism to notify traders that may have nearly matching prices but overlapping order quantities that they could achieve a trade with only a small change in their price. Also, by being a black box it fails to provide information that would indicate to traders that there is liquidity in the system in particular securities, so that they would know to pull back orders they may have placed elsewhere in order to participate in the POSIT® match. This approach further fails to enable the broadcast of information based on the activity in the system that may entice traders to enter orders when the system's participants have a higher than usual interest in a given security, this being an indication that the fill rates could then be expected to be higher. It also fails to provide the ability for a participant to initiate transactions at a time of his or her choosing. By pricing all trades at the midpoint, it also fails to provide any mechanism wherein a patient trader with a moderately sized block could draw a better price from a much larger or more anxious block order that would tend to drive the price adversely. Finally, it does not offer any ability for market participants to negotiate or otherwise actively participate in price formation through a process that could lead to the discovery of a fair price for a block trade.
Another system that attempts to manage information to facilitate large block trades is the LiquidNet Trading System. Users of this system contribute data regarding their trading interests directly from their Order Management Systems. When a user indicates an interest that matches contra interests already expressed within the system, all matched users receive an invitation to enter a negotiation session. If this invitation is accepted, the trader is expected to be firm and negotiate in good faith towards a trade; those that play with the system but fail to negotiate in good faith and close trades are expelled from the system. In the LiquidNet system, traders learn the existence of counter interests before anyone has entered negotiations; while this leakage is useful to entice traders to enter a negotiation process, it also leaks information about orders in the participants' Order Management Systems to parties that may or may not have a firm intention to trade. The system therefore relies on “fair play” by members of the network, which limits participation to a country club of like-minded Institutions. This fails to provide a system where the side of a trading interest can only be revealed to parties that have a firm, electronically executable contra order within the system at a reasonable price, and through this rule permits the participation of parties that have different incentives and trading horizons, including sell-side firms and hedge funds. The LiquidNet information management model, by leaking information regarding the side of a participant's order without a firm liability to trade, fails to achieve a proper balance between the need for confidentiality and the need to share some information in order to focus block interest in time, as can be achieved through means that indicate to traders that there is trading interest within the system without revealing the side of said interest until a trader has been exposed to a firm liability to trade. It also fails to provide the protection from gaming that can be achieved by a block crossing system wherein the only means to discover the side of a second participant's order is to place an aggressively priced large block order, which would then have a significant probability of being executed. By allowing orders of all sizes, the LiquidNet system also fails to provide a solution to the buyer's remorse problem, wherein a buyer that has a large order completely filled with great ease later fears that the contra had a much larger sell order whose residue is likely to drive the price down.
Harborside Plus offers another system to facilitate the crossing of blocks based on the management of trading interest information. In the Harborside system, traders are asked to send indications of interest into their database when they have an interest in buying or selling at least 25,000 shares of stock at the current midpoint price. These indications of interest are stored electronically and expire after a certain number of minutes, which depends on the client's trading style (for example, hedge funds or brokers tend to trade quickly so their indications will expire after only a few minutes). When there is an IOI on both sides in the security, a sales trader is notified through a popup window and will proceed to call the customers to close a trade. The mediation of a human trader is intended to ensure that the system is not abused by traders that would enter an IOI when in fact they do not have an interest to trade, since the damage to the relationship would make it less likely that this trader would get called again in the future. This system does not anticipate a trading system wherein fair play is enforced automatically by requiring traders to enter firm, electronically executable orders, that could either execute on arrival or be exposed to an execution from another party resident within such a system before the owner of said order receives any information back about other traders' interests. It also fails to provide any means for automating the negotiation process that is carried out by the sales trader. Since a sales trader is involved, it fails to provide the anonymity that traders expect from a computer system, where traders are enabled to negotiate directly with each other without leaking information to a third human being who may or may not be fully trusted. Finally, the Harborside system fails to anticipate mechanisms to entice other traders to express their trading interest in a security when there is evidence of trading interest on one side only. Finally, it fails to anticipate the possibility of showing information about one-sided trading interests without revealing the side, for the purpose of focusing interest in the security at this time without leaking price-impacting information to parties that have not expressed a firm liability to trade.
A fourth example of a system that attempts to manage information to facilitate block trades is the Liquidity Tracker facility, deployed by the Nasdaq Stock Market and subject of co-pending U.S. patent application Ser. No. 09/870,845, the entire contents of which are incorporated herein by reference. Liquidity Tracker enables a user to enter a firm order to trade and show information about this order to likely counter-parties. In the Liquidity Tracker system, the counter-parties are identified using real-time access to clearing information that Nasdaq participants submit through the Automated Confirmation and Transaction (ACT) system. By selectively targeting likely contra parties only, the intention is to avoid leaking information to other traders that could front run on the Institutional order or otherwise misuse this information for short term trading profit. However, since the Liquidity Tracker system only selects contra parties, the recipients will know if the first participant was a buyer or seller, i.e. the side of the order entry participant is not kept confidential. Some recipients of this information may be induced to stop or even reverse their trading direction instead of accepting the order, in the hope of seeing a better price later. While the level of confidentiality provided by the selection of targets is appropriate for somewhat larger orders than those that could be displayed on a public book, there are instances where traders with larger institutional blocks will feel uncomfortable with this level of confidentiality.
In this environment, there is an acute need for a confidential crossing system that enables users to place an order that will not be shown to anyone, but will nevertheless cause an information event that can help bring traders together at the same time in the same security.
In order to be productive rather than destructive, information events in a trade negotiation process should avoid two problems:                1. The preference revelation problem. Once a trader has displayed an interest to buy (sell) a fungible item, other participants that see this interest will increase (decrease) the value that they were placing on this item. In equity trading, showing a large buy (sell) order leads others to revise and perhaps cancel their intent to take a contra position. On the other hand, by not expressing a preference one misses the opportunity to trade altogether.        2. The buyer's remorse problem. When purchasing a fungible item, when the deal is closed with greater ease than expected, the buyer tends to assume that it was likely too good a deal for the other party. In the context of equity trading, when a large block order gets completely filled the trader would assume that the contra party's order was even larger and its residue would subsequently affect the price adversely as it gets worked in the marketplace. This problem is particularly acute for a system that caters to large Institutions.        